We upgrade IDFC to outperform with a revised target price of Rs 185 based on the sum-of-the-parts methodology as we increase our sustainable RoE to 18% from the current 15% on account of better margins and lower operational expenditure. Consequently, our target P/BV multiple goes up from 1.5x to 1.8x.
We also increase our FY14e and FY15e earnings by 4% on account of lower provisions. We believe IDFC is a good stock to play the reform story. Even if reforms were to take a backseat, IDFC can manage the risks and profitability well and additional cushion in the form of contingent provisions does exist.
The recent announcement of various reforms, though positive for sentiment, as such has not resulted in any new project proposals coming through. Loan growth of 36% seen in H1FY13 is unsustainable and will normalise around 20%.
IDFC is taking market share from mid-sized PSU banks. Many of the companies do not want the administrative hassle of having loan accounts with so many banks plus IDFC is also able to finance at a competitive rate. The management did admit that base rates have been sticky and if banks start dropping base rates, some of the refinancing business will disappear.
In our view, IDFC is managing funding profile very well. Despite having more refinance business and a larger share of operational projects in overall portfolio, 12 million spreads at 2.6% is close to the highest seen in the past seven years. This is mainly on account of its ability to tap effectively the bond markets, reduce dependence on bank funding and tap the ECBs and FII debt windows for IFCs effectively. As a result, IDFC has managed to keep a very tight leash on its cost of funds.
We also believe that risks to asset quality are manageable to a great extent. The management is very confident that NPLs are unlikely to cross a level of 1.5%. IDFC's loan loss reserves itself is at 1.6% and they might dip into the reserves if required.
Restructuring as such will continue, but that would be on a zero NPV loss basis and the company would restructure only those projects where there are temporary cash flow issues. As much as 80% of the project exposures of IDFC is operational. The biggest risk to asset quality is from gas-based power projects, where IDFCs exposure stands at 2.1%.